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The government is mulling the option of merging Bank of Baroda, IDBI, Oriental Bank, and Central Bank of India, which would create the country's second largest lender after State Bank of India. SHAMMI MEHRA/AFP

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The Indian government is mulling the privatisation of IDBI, one of the country’s public sector banks, but efforts to clean up the banking sector that is saddled with a $150 billion debt pile could be stymied by political opposition and lack of reforms at state-owned lenders, analysts say.

The Mumbai-based bank, like other public sector lenders in India - of which there are 21 in total - is burdened with huge levels of bad debt. IDBI's losses surged to more than 80 billion rupees (Dh4.29bn) in the last financial year, to the end of March, while its bad loans almost doubled to more than 555bn rupees. Given the scale of this problem plaguing the sector, there are mounting calls for privatisation and mergers of the country's state run banks, as a long term solution.

“The number of public sector banks has to come down significantly,” says Abhimanyu Sofat, the vice president of research at IIFL, a financial services company headquartered in Mumbai. “The problems are not getting solved.”

Indian public sector lenders have amassed large levels of bad debt as businesses have defaulted on loans following a borrowing spree and as the economic situation soured. Bad debts at India's banks have reached almost $150 billion, according to unpublished Reserve Bank of India data reported by Reuters. And the high-profile case of billionaire diamond jeweller Nirav Modi being accused of being at the centre of a $2bn bank fraud at a single branch of India's second largest state-owned lender, Punjab National Bank, has raised further questions about the need to take a closer look at the structure of the entire public sector banking industry.

But privatisation could be “difficult to execute”, says Alka Anbarasu, the vice president, financial institutions group at Moody’s Investors Service.

“Except IDBI, most of the other banks operate under the nationalised bank act, so if the banks need to be privatised, a number of legal changes will need to be instituted and in fact the changes will have to go through the parliament so it can take a long time,” explains Ms Anbarasu.

She also questions whether there would be interest and how the banks would fare under private ownership.

“We don't know if a private partner would be willing to step into the government’s shoes in these banks given the way the banks operate and the insolvency challenges,” she says. “The depositor confidence in these banks remains strong because they're sovereign backed. If these banks were to be privatised, we don't know how the depositors will react to that step by the government.”

For privatisation in particular to take place, the banks would have to be made a far more attractive investment option.

“There has to be some kind of incentive to the ultimate buyers of these banks, where people get interested in running these banks,” says Mr Sofat.

Consolidation is perhaps a more realistic option for the sector, analysts say.

The government is mulling the option of merging Bank of Baroda, IDBI, Oriental Bank, and Central Bank of India, which would create the country's second largest bank after State Bank of India, displacing Punjab National Bank as the No. 2 lender, according to business newspaper Mint, citing anonymous sources with knowledge of the matter.

Indeed, some consolidation has already taken place. Last year, State Bank of India in April merged five of its associate banks and Bharatiya Mahila Bank. Several other public sector lenders reportedly submitted consolidation plans to the finance ministry.

The government has been outspoken about consolidation being an answer to the sector's woes, and comments have been made by officials that the number of public sector banks could be halved.

“We think consolidation of the public sector banks could result in a positive outcome in the longer term,” says Ms Anbarasu. “The public sector banks have a very homogenous stream of revenue because they tend to lend to the same set of customers.”

Such a move could help create a more stable banking system, she adds.

“The surviving banks could have cost cuts from cutting their overlapping operations and also the banks will benefit from better supervision and even from the government perspective, managing 8 to 10 public sector banks might be easier than managing 21 public sector banks,” she says.

Public sector banks, including State Bank of India and IDBI, declined to comment.

But there is an argument that the sector needs to be cleaned up before embarking on such an overhaul.

A number of steps have already been taken to cleanse the system. India two years ago introduced a new insolvency and bankruptcy code to make it easier for banks to recover money owed to them.

Last month, Tata Steel, part of the sprawling Tata conglomerate, announced its buyout of a majority stake for 364bn rupees in New Delhi-based manufacturer Bhushan Steel, the first company to successfully emerge from India’s strict new insolvency and bankruptcy regime. Bhushan Steel was one of the first major defaulters to be targeted under India’s insolvency and bankruptcy code.

Eleven state run lenders, including IDBI, have been placed under the Reserve Bank of India's prompt corrective action framework, a mechanism to monitor, control and take corrective action on weak banks.

In addition, the government towards the end of last year announced as $32bn recapitalisation plan for the banking sector.

This month, the acting finance minister Piyush Goyal announced a committee to look at setting up an asset management company, or a “bad bank” to help manage the state-owned banks' non-performing assets.

But the prospect of privatisation and consolidation has spooked many employees in the sector, who fear the widespread redundancies that could result from such steps.

“We are not responsible for the banks' losses,” says Devidas Tuljapurkar, the joint secretary of the All India Bank Employees Association, a trade union. “Why should we be the ones who are punished?”

But there are doubts over whether the government will be able to execute any such major changes when it comes to privatisation or consolidation in the near term, anyway.

“We doubt the government has many options to address the problem of public sector banks over the next one to two years given the political and social challenges of privatising these banks,” says Sanjeev Prasad, senior executive director and co-head of institutional equities at Kotak Securities

With a general election coming up next year, this could make it difficult to overhaul the sector before that, he explains.

Furthermore, he says that more fundamental reforms in the banking sector need to take place first.

“We do not see any reason for the government to give large amounts of capital to weak public sector banks or force consolidation among banks without it addressing the fundamental issues

of governance,” says Mr Prasad.

The high-profile case of Mr Modi has raised further questions about the need to take a closer look at the structure of the entire public sector banking industry. But given the severity of the challenges that are weighing on India's public sector banks, it is clear whether the sector needs some form of drastic change, which may not prove immediately popular but could ultimately benefit the wider economy.